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FINDING THE FOREX BULL MARKET IN THE EU CRISIS: PART 2

Most Markets May Plunge When EU Anxiety Is High-But In Forex There’s Always A Bull Market Somewhere

Here In Part 2 We Go Beyond The Distinction Between Risk & Safe Haven Currencies, And Cover How To Profit From It

Any prudent investor now needs a basic grasp of foreign exchange (forex) markets. Economic policies are eroding the value of most major currencies and anything denominated in them. The following is an excerpt from The Sensible Guide To Forex: Safer, Smarter Ways to Prosper from the Start. In this excerpt we cover some forex basics that all investors can use right away to improve their returns, even if they never trade forex.

There are a number of ways this understanding can vastly improve your performance.

They Help You Plot Strategy Based On Correlations and Divergences

Whether a currency pair is a risk or safety pair determines how it correlates with other kinds of assets. You can profit from understanding that correlation. Here are just a few examples.

When risk assets are rising, you want to have long positions on risk pairs like those mentioned above. There are many ways to do that besides buying the pair on the spot market. For example, you could buy call options (normal or binary options).

When risk assets are falling, you want to have short positions on risk pairs like those mentioned above. Again, there are multiple ways to do that.

When we see a divergence in that correlation that is, if a risk or safety currency pair isn’t moving in the same direction as other risk or safety assets, that’s usually an advanced warning of a change in direction for those assets or the currency pair – because one of them is lagging behind the other. For example, if stocks are rising but the AUDJPY and other risk pairs are falling, that could mean stocks will soon head lower, and it’s time to get ready to short (buy puts on) the major stock indexes.

Risk Barometers To Watch

So how can you get a quick read on whether markets are in “risk on” or “risk off” mode? Here’s an abbreviated list excerpted from the book. Some of the most widely followed risk barometers (that are easy to find in the mainstream press) include price action of:

Major Global Stock Indexes: Regardless of whether you’re watching the Asian, European, or American trading session, the big indexes tend to move together, and their overall performance is usually a good indicator of the market’s mood.

Industrial Commodities like copper and oil

Bond Prices and Yields of Sovereign Debt of the Largest Economies: For example, in times of fear US, German, and Japanese government bond prices rise and their yields fall as investors bid up the price of these classic safe haven assets. Their yields fall as their prices rise because their periodic coupon payments are fixed, so yield moves in the opposite direction of the price.

Another excellent barometer is Credit Default Swap (CDS) spreads: These are the differences (spreads) between the cost of buying insurance against a bond default for a given higher risk bond and a benchmark low risk bond like US or German bonds. The key thing to know is that the wider the spread for a given bond, the more expensive the insurance, and so the riskier the bond is considered compared to the benchmark bond. Throughout the EU debt crisis, movements in the CDS spreads and bond yields of the GIIPS nations have been closely followed as prime barometers of the creditworthiness of a given nation or bank. When these are flat of trending lower, the crisis is in remission. When they’re spiking, markets are scared and risk assets usually are moving lower.

Understand How Events Can Affect Currencies and Other Markets

Obviously, any positive news is good for risk assets and currencies, and bad news helps safe haven assets.

More significantly, you understand why and how certain kinds of events could hit markets harder than others. For example, because currency risk rankings and prices are so strongly impacted by their short term interest rates, the impact of a certain news item is often in direct proportion to how it affects interest rate expectations for that currency. If a news item changes these expectations, it can override normal correlations between the currency and other assets.

Case Study: The USD And US Monthly Jobs Reports

A classic case of a news item altering normal currency behavior that we’ve seen in recent years is when US monthly job reports are much better or worse than expected, the safe haven USD can suddenly start performing like a risk asset. When the jobs report is much better than expected, it actually rises along with stocks and other risk assets, even against most or all other currencies with higher risk rankings. That’s because it’s well known that the Fed won’t raise interest rates until employment improves substantially. Therefore strong signs of an improving employment picture raise expectations for rate increases, which increases demand for dollars as traders anticipate a rising USD. Strong jobs reports also suggest growth, which causes stocks and other risk assets to rise. Thus we see the safe haven USD rising along with risk assets, and outperforming many or all risk currencies.

Similarly, when US monthly jobs reports are surprisingly bad, the USD again performs out of character and instead of rising with other safe haven assets, it falls along with other risk assets, for the same reasons noted above. Expectations for rate increases have changed, only this time, for the worse.

In both cases, the USD remains a safe haven currency. While it’s moving like a risk asset, it’s doing so for a different reason.

When there’s good jobs data, the USD is appreciating due to rising interest rate expectations. Other risk assets, however, are rising due to improving growth expectations. That change overrides normal correlations between the safe haven USD and risk assets. Traders that understand this don’t view this behavior as divergence that signals a change in market behavior, and they can plan their trades and trade strategy. There are other factors and details that can influence the normal risk and safe haven asset correlations, and we cover them in greater depth in the book, but the above is a good foundation for understanding the importance of understanding how correlations between risk and safe haven assets operate, and how they can change.

Now that you’ve got the above background information on risk and safe haven currencies, their correlations and how to use them, you’re ready for Part 3- finding the profit opportunities in forex markets from the EU crisis. It should be up within the coming week.

While forex markets are typically associated with high risk, complex, time consuming short term trading, there are many safer, simpler ways that conservative investors or traders with limited time and skills can tap forex markets for currency diversification and currency diversified income. To learn more about how to improve your returns through conservative forex trading and investing, take a look at The Sensible Guide To Forex: Safer, Smarter Ways to Prosper from the Start.

It’s the only book specifically written to show mainstream investors how to survive and hedge currency risk posed by unprecedented money printing by most major central banks, and how to prosper by safer, simpler ways to exploit forex and commodity markets, either as conservative traders or income investors, for lower currency risk and better returns. It’s essential reading for all investors, because a good investment in a bad currency is a bad investment. Click here for a description of the book, and here for advanced reviews. It’s due out in September 2012, reserve your copy by clicking here.